Price multiples are commonly used to determine the equity value of a company. The relative ease and simplicity of these relative valuation methods make them among the favorites of institutional and retail investors.
Price-to-earnings, price-to-sales, and price-to-book values are typically analyzed when comparing the prices of various stocks based on a desired valuation standard. The price-to-cash-flowmultiple (P/CF) falls into the same category as the above price metrics, as it evaluates the price of a company's stock relative to how much cash flow the firm is generating.
Key Takeaways
- Theprice-to-cash-flowmultiple measures the price of a company's stock relative to how muchcash flowit generates.
- There are multiple ways to calculate cash flow, but free cash flow is the most comprehensive.
- To gauge whether a company is under or overvalued based on its price-to-cash-flowmultiple, investors need to understand the industry context in which the company operates.
Calculating the Price-to-Cash-Flow Ratio
P/CF multiples are calculated with a similar approach to what is used in the other price-based metrics. The P, or price, is simply the current share price. In order to avoid volatility in the multiple, a 30- or 60-day average price can be utilized to obtain a more stable value that is not skewed by random market movements.
The CF, or cash flow, found in the denominator of the ratio, is obtained through a calculation of the trailing 12-month cash flows generated by the firm, divided by the number of shares outstanding.
Let's assume that the average 30-day stock price of company ABC is $20—within the last 12 months $1 million of cash flow was generated and the firm has 200,000 shares outstanding. Calculating the cash flow per share,a value of $5 is obtained (or $1 million ÷ 200,000 shares). Following that, one would divide $20 by $5 to obtain the required price multiple.
Also, note that the same result would be determined if the market cap is divided by the total cash flow of the firm. The P/E ratio is a simple tool for evaluating a company, but no single ratio can tell the whole story.
Different Types of Cash Flow
Several approaches exist to calculate cash flow. When performing a comparative analysis between the relative values of similar firms, a consistent valuation approach must be applied across the entire valuation process.
For example, one analyst might calculate cash flow as simply adding back non-cash expenses such as depreciation and amortization to net income, while another analyst may look at the more comprehensive free cash flow figure. Furthermore, an alternative approach would be to simply sum the operating, financing, and investing cash flows found within the cash flow statement.
While the free cash flow approach is the most time-intensive, it typically produces the most accurate results, which can be compared between companies. Free cash flows are calculated as follows:
FCF = [Earnings Before Interest Tax x (1 – Tax Rate) + Depreciation + Amortization – Change in Net Working Capital – Capital Expenditures]
Most of these inputs can be quickly pulled from a company's financial statements. Regardless of the approach used, it must be consistent. When trying to evaluate a company, it always comes down to determining the value of the free cash flows and discounting them to today.
Relative Value Analysis
Once the P/CF ratio is calculated, the initial result does not actually reveal anything of great significance to the analyst. Similar to the subsequent procedure for relative value methodologies—which use the P/E, P/S, and P/BV multiples—the calculated P/CF must be assessed based on comparable companies.
A P/CF of five does not actually reveal much useful information unless the industry and stage of life for the firm are known. A low free-cash-flow price multiple may be unattractive for an established slow-growth insurance firm,yet present a solid buying opportunity for a small biotech startup.
Basically, to get a sense if a company is trading at a cheap price relative to its cash flows, a list of appropriate comparables must form the comparison benchmark.
Advantages and Disadvantages of the P/CF Ratio
There are several advantages that the P/CF holds over other investment multiples. Most importantly—in contrast to earnings, sales, and book value—companies have a much harder time manipulating cash flow. While sales, and inevitably earnings, can be manipulated through such practices as aggressive accounting, and the book value of assets falls victim to subjective estimates and depreciation methods, cash flow is simply cash flow. It is a concrete metric of how much cash a firm brings in within a given period.
Cash flow multiples also provide a more accurate picture of a company. Revenue, for example, can be extremely high, but a paltry gross margin would wipe away the positive benefits of high sales volume. Likewise, earnings multiples are often difficult to standardize due to the variable accounting practices across companies. Studies regarding fundamental analysis have concluded that the P/CF ratio provides a reliable indication of long-term returns.
When analyzing an investment, investors should utilize multiple financial metrics rather than just one in order to get a complete picture.
Despite its numerous advantages, there are some minor pitfalls of the P/CF ratio. As previously stated, the cash flow in the denominator can be calculated in several ways to reflect different types of cash flows. Free cash flow to equity holders, for example, is calculated differently than cash flow to stakeholders, which is different from a simple summation of the various cash flows on the cash flow statement. In order to avoid any confusion, it is always important to specify the type of cash flow being applied to the metric.
Secondly, P/CF ratios neglect the impact of non-cash components such as deferred revenue. Although this is often used as an argument against this multiple, non-cash items such as deferred revenue will eventually introduce a tangibleor measurable cash component.
Finally, similar to all multiple valuation techniques, the P/CF ratio is a "quick and dirty" approach that should be complemented with discounted cash flow procedures.
What Is a Good Price-to-Cash-Flow Ratio?
A good price-to-cash-flow ratio is any number below 10. Lower ratios show that a stock is undervalued when compared to its cash flows, meaning there is a better value in the stock. This can be perceived as a signal to buy.
Is Too Much Free Cash Flow Bad?
Yes, too much free cash flow can be bad. It signifies that a company is not utilizing its cash efficiently. Having cash on hand is good but if it is not generating any returns, it will lose value over time due to inflation. It is better to invest a portion of cash and generate investment returns.
What Is a Good Price-to-Equity Ratio?
A good price-to-equity (P/E) ratio is one that is between 20 and 25. The lower the P/E ratio, the better. When analyzing P/E ratios, it's important to do so in the context of the industry the business operates. Different industries will have different P/E ratios that are considered good, so one must compare apples to apples.
The Bottom Line
Analyzing the value of a stock based on cash flow is similar to determining whether a share is under or overvalued based on earnings. A high P/CF ratio indicates that the specific firm is trading at a high price but is not generating enough cash flows to support the multiple—sometimes this is OK, depending on the firm, industry, and its specific operations.
Smaller price ratios are generally preferred, as they may reveal a firm generating ample cash flows that are not yet properly considered in the current share price.
Holding all factors constant, from an investment perspective, a smaller P/CF is preferred over a larger multiple. Nevertheless, like all fundamental ratios, one metric never tells the full story. The entire picture must properly be determined from multiple angles (ratios) to assess the intrinsic value of an investment. The P/CF multiple is simply another tool that investors should add to their repertoire of value-searching techniques.
